Is your professional firm prepared for new ‘work in progress’ rules?

Changes introduced as part of the 2017 federal budget are set to have a significant impact on the cash flow of professional firms over the next several years. These provisions change how “work in progress” is calculated and limit opportunities for income deferral for accountants, dentists, lawyers (including notaries in Québec), medical doctors, veterinarians, and chiropractors.

Our team has considered these changes to determine what impact they will have on your firm and what practical steps you can take to help you plan ahead.

Deferral no longer available for overhead

In the context of professional firms, “work in progress” (WIP) corresponds to the accumulated value of time and resources expended on a client project that has not yet been invoiced. On a balance sheet, WIP typically includes two components: the actual cost of providing the service, and the profit margin. WIP is converted into a receivable once the bill is issued to the client.

Until now, professional firms were allowed not to record WIP as income for tax purposes, but under new rules enacted following passage of the 2017 federal budget, this deferral is only available for the profit portion of the WIP.

As an example, once the new rules are fully implemented if your professional firm has $100 in un-invoiced services for client A, of which $40 is costs, you will be required to report that $40 as income even though no bill has been sent. Thus, the “income” for this portion of your WIP will be reported to CRA in the same period as you report those costs. You will still be able to defer the profit portion of $60 until the work is billed.

In order to allow for a smoother transition period, implementation of these measures will take place gradually over five years, in 20% increments. So, in the example above, assuming the firm’s work in progress remains consistent over the five years, the cost portion of your WIP deferral will be reduced by $8 each year until 2022. If the cost portion of work in progress increases or decreases the previous year’s income inclusion will be deducted in the current year and the firm will include the appropriate amount of cost in income for that year (year 2 – 40%, year 3 – 60%, etc.)

Be prepared by establishing a methodology and reviewing cash flow

What steps can you take to prepare for these changes? The initial step is to calculate the cost of your firm’s WIP, and to do this you must use one of two methods: direct costing or full absorption. While the first method mainly includes staffing costs, the second method takes into account general overhead expenses. Here, the key is to choose the method which is most appropriate based on your firm’s activities.

Another consideration in calculating your firm’s WIP is that it corresponds to the lower of cost or net realizable value. The new rules provide that contingency files generally have a net realizable value of zero, because work performed for the client in those circumstances is considered to have no value until the time of billing.

This may be an important consideration for firms that deal mostly with contingency accounts. As a first step, if your firm has a number of contingency files, these should be clearly separated from other files to facilitate the calculation of WIP.

Finally, understanding how this change will affect your business’ finance and operations is an issue of immediate concern. Most firms subject to these rule changes will feel the impact in their cash flow, so assessing how changes to cash flow will affect your business is a logical step. Your professional tax advisor can help you navigate these changes, and factor them in your firm’s business planning.